Institute of
Certified Public Accountants
of Kenya
Technical Release No. 9/2003
Guidance on Assessment of Appropriate
Discount Rates for use in Market-Based
Discounted Cash:flow Valuation of
Biological Assets Under lAg 41
The information contained in this publication is the property of the
Institute of Certified Public Accountants of Kenya. Reproduction in any
form whatsoever without prior authority is prohibited.
@ ICPAK
December 2003
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1.
Background
IAS 41 requires biological assets to be measured at initial recognition and at each
subsequent balance sheet date at fair value less estimated point-of-sale costs. The
Standard prescribes that, where an active market for biological assets exists, the
quoted price in that market is the appropriate basis for determining the fair value of
that asset. An active market is one where the items traded are homogeneous, willing
buyers and sellers can be found at any time and prices are available to the public.
The Standard goes on to state that if an active market does not exist, then the
enterprise should use one or more of the following methods in determining fair value
of its biological assets:
(a) the most recent market transaction price, provided that there has not been a
significant change in economic circumstances between the date of that
transaction and the balance sheet date;
(b) market prices for similar assets with adjustment to reflect differences; and
(c) sector benchmarks such as the value of an orchard expressed per export tray,
bushel, or hectare, and the value of cattle expressed per kilogram of meat.
However, in common with other emerging markets, in Kenya active markets often
do not exist for the type of biological assets that agricultural enterprises own (e.g.
coffee and tea bushes, cashew nut trees, sisal plants). Further, market-determined
prices or values are not readily available for the prescribed alternatives that would
allow the enterprise to value the biological assets in their present condition and
location. In these circumstances, enterprises are required to use the present value of
expected net cash flows from the biological asset discounted at a current marketdetermined pre-tax rate in determining fair value as set out in paragraph 20 of IAS
41.
2.
Issue
Where the present value of expected net cash flows is to be used, the issue of the
appropriate discount rate has arisen with particular interest on whether it is possible to
have a single rate for the entire agricultural sector.
In addressing the issue, it has been observed he use of discounted cash flow method of
valuation suffers from inherent complexities as described below:
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i. the need to project appropriate expected net cash flows that reflect:
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the requirement to value the biological assets in their present condition and
location while excluding increases in value attributable to additional biological
transformation and future activities of the enterprise, such as those related to
enhancing the future biological transformation, harvesting, and selling, and;
the fact that actual cash flows arising from agricultural activity are inherently
uncertain and that actual cash flows will vary from one period to the next and,
in any given period, will almost certainly differ from the ex-ante expected cash
flows for the period
ii. the need to estimate an appropriate market-determined pre-tax discount rate that
reflects the characteristics of the underlying cash flows and deals properly with
uncertainty.
As set out above, cash flows arising from agricultural activity are inherently uncertain and
variable. This is because of a variety of factors including the impact of changing weather
patterns, changes in the world-market prices for agricultural produce (which is often a
commodity product where prices reflect world supply and demand conditions), the impact
of exchange rate changes on cash flows arising from exported produce and from imported
inputs such as fertilizer.
IAS 41 recognises that cash flows from agricultural activity are inherently variable. The
standard states, "In agreeing an arm's length transaction price, knowledgeable, willing
buyers and sellers consider the possibility of variations in cashflows. It follows thatfair
value reflects the possibility of such variations. Acc.ordingly,an enterprise incorporates
expectations about possible variations in cashflows into either the expected cashflows,
or the discount rate, or some combination of the two. In determining a discount rate, an
enterprise uses assumptions consistent with those used in estimating the expected cash
flows, to avoidthe effectof someassumptionsbeingdouble-countedor ignored." (IAS
41 paragraph 23).
Further, as set out in paragraph 5.1.3 of International Valuation Guidance Note number 9
(Discounted Cash Flow Analysis for Market and Non-market-based Valuations)International Valuation Standards, Sixth Edition - discounted cash flow model, cash flow
can be developed on a variety of bases including before-tax, after-tax, nominal or real
(adjusted for inflation) bases. Cash flows can also be expressed in a variety of currencies
e.g. US dollars where agricultural produce from the biological assets is primarily exported
and subjected to world-market prices denominated in dollars or Kenya shillings where
most of the inputs and proceeds are denominated in that currency.
It is a fundamental principle of discounted cash flow analysis that the discount rate used to
discount cash flows should be consistent with the nature of the projected cash flows. As
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set out in paragraphs 5.14.2.2.5 and 5.14.2.2.5 of International Valuation Guidance Note
number 6 (business valuations):
(a) The capitalization rate or discount rate should be consistent with the type of
anticipated benefits used (e.g. pre-tax rates should be used with pre-tax benefits);
(b) Where the forecast income is expressed in nominal terms (current prices), nominal
rates must be used and where the forecast income is expressed in real terms (level
prices), real rates must be used.
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Discount rates need to reflect the nature of the underlying cash flows hence there
is no single common appropriate discount rate to value biological assets. In
summary, therefore, it is not possible to arrive at a single common marketdetermined discount rate that would be appropriate to use in discounted cash flow
analysis to value biological assets in Kenya (or indeed elsewhere).
The appropriate discount rate will depend on three key factors:
i.
How expectations of variations in cash flows have been incorporated into the
cash flows and what the relative level of variation from the baseline expected
cash flows is likely to be in the future
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3.
The basis on which the cash flows have been prepared (e.g. in real terms or in
nominal terms) and the level of general inflation estimates implicitly or
explicitly assumed in preparing the cash flows!
The currency in which the cash flows are expressed (e.g. in US dollars or in
Kenya shillings).
Recommendation
Valuations should be completed or reviewed by professional valuers
Clearly, given these complications, preparing reasonable and realistic estimates of the
fair value of biological assets using discounted cash flow techniques requires the
exercise of specific skills and expertise in the application of such techniques
(particularly in emerging market requirement) and the exercise of professional
judgement within internationally accepted frameworks.
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Note - IAS 41 requires cash flows to be stated on a pre-tax, pre-financing basis hence discount rates
also have to be stated on this basis
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Consequently, 1CPAK recommends that valuation of biological assets should be
completed by or reviewed by professional valuers, as is common with other assets
such as land, fixed assets and shares as well as the valuation of post-employment
benefuobligations under/AS 19.
The professional valuers must have the knowledge, skills and experience to complete
the assignment efficiently in relation to an acceptable professional standard. In
particular, the valuer should be skilled in the application of discounted cash flow
techniques in emerging markets and should be familiar with relevant International
Valuation Standards and guidance notes.
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